My not-so-profound thoughts about valuation, corporate finance and the news of the day!

Thursday, March 1, 2012

Apple: Thoughts on bias, value, excess cash and dividends

Apple is hitting or is close to hitting two significant landmarks. Its market cap exceeded $ 500 billion yesterday (2/29) and its cash balance is at $ 100 billion. The twin news stories seem to have set investors, analysts and journalists on a feeding frenzy. I think it is ironic that a company doing as well as Apple is right now, in terms of operations and stock price performance, is receiving this much unsolicited advice (split the stock, pay a dividend, buy back stock, do an acquisition, borrow money) on how it should fix itself. As we look at these prescriptions being offered to one of the healthiest companies in the market today, we should heed the Hippocratic oath, which is to do no harm.

I am biased
I have to start with a confession. It is impossible for me to be objective in my analysis of Apple and it is not just because the stock has done so well for me over the last decade. My first computer was a Mac 128K that I bought in the early 1980s and I have bought every Apple model since (even the ill fated Lisa and the not-so-great Powerbook Duo). Why should you care? One reason that the debate on Apple is so heated is that people have strong preconceptions about the company and those preconceptions drive their suggestions about what the company should do. As you read the rest of this assessment, you should recognize that my substantial positive bias towards Apple does affect my analysis. To structure my thoughts about what Apple should do, here is how I see the choices for the company:

Is Apple's cash hurting its stockholders?
The first and most critical question is whether Apple's cash holdings are doing harm to the stockholders. Let's dispense with the reasons that don't hold up to scrutiny:1. Cash earns a low rate of return: It is true that Apple's cash balance earns a very low rate of return. It is, after all, invested in treasury bills, commercial paper and other investments that are liquid and close to risk less. It earns less than 1% but that is all it should earn, given the nature of the investments made. Put differently, cash is a neutral investment that neither helps nor hurts investors.2. If that cash were paid out, investors in Apple could generate higher returns elsewhere: Perhaps, but only by investing in higher risk investments. Investors in Apple, who were concerned that Apple was investing so much in low return, low risk cash could have eliminated the problem, by buying the stock on margin. Borrowing roughly 20% of the stock price to buy Apple stock would have neutralized the cash balance effect and would have been a vastly more profitable strategy over the last decade than taking the cash out of Apple and searching for alternative investments.

So, what could be defensible reasons for worrying about cash? Here are a few:1. The "low leverage" discount: The tax laws are tilted towards debt and Apple by accumulating $ 100 billion in cash, with no debt, is not utilizing debt's tax benefits. In fact, the gargantuan cash balance gets in the way of even talking about the use of debt at the company; after all, why would you even consider borrowing at 2 or 3% interest rates, when you have that cash balance on hand?My assessment: By my computation, Apple's optimal debt ratio is about 40-50% (download the spreadsheet to check it out yourself) and its current net debt ratio is -20% (using the cash balance of $ 100 billion as negative net debt). Given the risk of the business that Apple operates in, I would not let the debt ratio go higher than 20-30%. Their cost of capital currently is about 9.5% and it could drop to about 9% with the use of debt. That would translate into a value increase of $20-25 billion for the company, not insignificant but that is about a 5% value increase.

2. The naiveté discount: It is undeniable that legions of investors still use the short hand of a PE ratio, often estimated by looking at an industry average, applied to current or forward earnings to get a measure of whether a stock is cheap or expensive. In the process, they can significantly under value companies that have disproportionate amounts of cash. To see why, assume that the average trailing PE ratio for electronics/computer companies is 14 and that the average company in the sector has no cash. If you apply that PE ratio to Apple's net income or earnings per share, you are in effect applying it not only to the earnings from its operating assets (where it is merited) but also to its earnings from its cash balance (where you should be using a much higher PE ratio). Thus, you will come up with too low a value for Apple.My assessment: I would be more inclined to go along with this argument if Apple's stock price had dropped 50% over the last few years. I find it difficult to believe that after the run up that you have seen in Apple's stock price, stockholders are under valuing the company. The counter, of course, is that the PE ratio for Apple, at 16 times trailing earnings or 13-14 times forward earnings, seems low and may reflect a naiveté discount.

3. The stupidity discount: In a post on Apple more than a year ago, I referred to what I called the stupidity discount, where stockholders discount cash in the hands of some companies because they worry about what the company might do with the cash. If investors are worried that the managers of a company will find a way to waste the cash (by taking bad investments, i.e., investments that earn less than the risk adjusted rate of return they should make), they will discount the cash.My assessment: My personal assessment in January 2011 was that, as an Apple stockholder (which I have been for more than a decade), the company had earned my trust and that I was okay with them holding my cash. I am open to a reassessment and I think any disagreement boil down to the answer to the following question: Do you believe that Apple's success and strategy over the last decade was attributable to Steve Jobs or Apple's management? If you believe it was Steve Jobs, you are now in uncharted territory, with Tim Cook, a capable man no doubt, but capable men (and women) have wasted cash at other high profile companies. If you believe that Apple's management team was responsible for its success over the period, your argument is that nothing has really changed and that you see no need to change your views on the cash.

What if there is no discount?
If the cash balance is not hurting Apple's stockholders right now, the pressure to return the cash immediately is relieved. However, you still have a follow up question to answer. Does Apple see a possibility that it could find productive uses for the cash? While Jobs never broached that question and preserved plausible deniability, I am afraid that Tim Cook has conceded on this issue, when he said last week that Apple had more "cash than we need to run the company".

Bottom line: I am inclined to believe that Apple is not being punished right now for holding on to $100 billion in cash. However, I am more concerned than I was a year ago. While I had the conviction that Steve Jobs could never be pressured (by investors, portfolio managers or investment banks) to do something he did not want to do, I am not as sure about Tim Cook. Having seen how quickly markets can turn on high flying companies (Microsoft and Intel in the early part of the last decade come to mind), in the face of disappointment or a misstep, I am worried that Apple may be one misstep away from a discount being attached to cash. Given that even Tim Cook does not think that Apple needs this big a cash balance, I think that it is time that we ask the follow up question: what should Apple do with all this cash?

What should Apple do with the cash?
In the broadest sense, Apple can either invest the cash or return it to stockholders and it seems that even Apple does not believe in the first option. Investing the cash internally in more products and projects sounds like a great idea, given Apple's track record over the last decade. In 2011, for instance, the company generated a return on equity of 42% on its investments; if you net the cash out of book equity, the return on equity exceeds 100%. If Apple could invest the $100 billion in cash at 42%, that cash would be worth $350 billion, but put those dreams on hold, because it is not going to happen. First, that high return on equity can be traced back to the blockbuster products that Apple introduced in the last decade, the iPod, the iPhone and the iPad, and those are not easily replicable. Second, there are other constraints (people, technology, marketing, distribution, production) that essentially limit the number of internal projects that Apple can take.

How about a few acquisitions? I am sure that there are willing and eager bankers who will find target companies for Apple. The sorry history of value destruction that has historically accompanied acquisitions of large publicly traded companies leads me to believe that this path of action will provide justification for those who attached a stupidity discount in the first place. So, to those who are counseling Apple to buy Yahoo!, Pandora, Linkedin or go bigger, please go away!

If Apple cannot find internal projects of this magnitude and the odds are against value creation from acquisitions, the company has to return the cash to investors and there are three ways it can do this: initiate a regular dividend and tweak it over time, pay a large special dividend or buy back stock. In my view, there are four factors that come into play in making this choice:

Urgency: A company with a large cash balance that has been targeted by an acquirer or activist investors has to return cash quickly, cutting out the regular dividend option. Apple's large market cap protects it from hostile takeovers and its stock price performance and profitability give it immunity from activist investors.

Stockholder composition: When a company that has never paid a regular dividend initiates dividend payments, it attracts new investors, i.e., investors who need or like dividends, into the company. While this "investor expansion" has been used as an argument for regular dividends, I think it should actually be an argument against regular dividends. While some of my best friends are "dividend investors", I think that they are temperamentally and financially a bad fit for Apple, a immensely profitable company that also operates in a shifting, risky landscape. If Apple initiates a dividend, the demands for increases in those dividends in future years will come and the company will find itself locked into a dividend policy that it may or may not be able to afford.

Tax effects (for investors): The choice between dividends and stock buybacks is also affected by how investors in the company will be taxed as a result of the transaction. While both dividends and capital gains are still taxed at the same rate, that will change on January 1, 2013, when the tax rate on dividends reverts back to the ordinary tax rate (which could be 40% or higher). If Apple drags its feet into 2013, the choice becomes a simple one: buy back stock.

Valuation of stock: Finally, there is the question of whether the stock in the company is under or over valued. A company, whose stock is over valued, should pay a special dividend since buying back shares at the inflated price hurts the stockholders who remain after the buyback. While I am normally skeptical of the capacity of management to make judgments about the "fair" value of the stock, I decided to take my best shot at valuing Apple using an intrinsic valuation model. Using what I thought were reasonable assumptions (8% revenue growth for 5 years and a 30% target margin, both significantly lower than the numbers from recent years), I estimated a value of $716 $710 per share for Apple. You can download the spreadsheet that I used to make your own judgment. Once you have made your own estimates, please enter them in this shared Google spreadsheet. A buyback at the current price would provide a double whammy: a reduction in a "too large" cash balance and a buyback at a price lower than value. (Update: As many of you have rightly pointed out, a significant portion of the cash is trapped overseas and Apple will have to pay the differential tax rate (between the US marginal tax rate and the foreign tax rate already paid) when the cash is repatriated. I have added the trapped cash input into the excel spreadsheet and factored in the additional taxes.)

Closing thoughts
Apple should announce a substantial buy back, but it should use it do so on its terms. First, the buyback should leave Apple with enough of a cash balance (my guess is about $15-$20 billion) to invest in new businesses of products, should they open up. For the moment, I would avoid the debt route, even though Apple has debt capacity. Second, Apple should follow the Berkshire Hathaway rule book and set a cap on the buyback price. While Berkshire Hathaway's cap is set in terms of book value (less than 110% of book value), Apple should set its maximum as a function of earnings or cash flows (say, 16 times earnings). Third, Tim Cook should stop talking about whether Apple has too much cash and get back to business. Make the iPad 3 a success and lets see an iTV, an iAirline, a iUniversity and an iAutomobile (think of any product you use now that is badly designed or a business that is badly run and think of how much better Apple could do...). Apple did not get to be the largest market cap company in the world by finessing its capital structure or optimizing dividend policy. It did so by taking great investments.

44 comments:

Shailesh
said...

Very clear thoughts!

but does the tax deductibility of interest expense really make debt cheaper than equity? Over time, people demand more debt funds (to enjoy the tax advantage) increasing the cost of debt to the point where it equals the risk-adjusted cost of equity?

The tax deductibility of interest is the only reason that debt is cheaper than equity. It is true that creating your own offset to the cash can cost more than 1%, but not that much more. I did think about the fact that a big portion of the cash balance is trapped overseas and that Apple has to pay the differential tax rate (between the overseas tax rate and the US tax rate). That could reduce the value of the cash balance. For instance, $30 billion is trapped overseas, and it has already been taxed at 15%, Apple would have to pay an extra tax of $ 6 billion. You would have to knock that off the value.

Even though the dividend and capital gains rates are currently the same, I think you are neglecting an important distinction between the two. If Apple were to repurchase shares, equity holders would have the ability to defer the capital gain simply by continuing to hold onto the stock. By distributing a dividend, Apple would force shareholders to immediately recognize the gain.

I frankly don't understand why dividends continue to be relevant given the alternative of share repurchases. I understand that some people prefer dividends to home-made capital gains through selling shares, but these people are irrational.

If regular (i.e. quarterly) share repurchases took place of quarterly dividends, it seems like it would mitigate the information asymmetry problem caused by irregular share repurchases....since we would expect share prices to be fairly priced, on average, over time.

Brian,You are right on the timing option but it is also true that you are closer to indifference this year than you will be next year. As for why some investors prefer dividends, that is a question for another post (perhaps my next one).

My recent epiphany is that all taxable shareholdings could be transformed into tax-deferred holdings if all firms would adopt a "no-dividend" policy. That is, if no firms paid dividends, and investors were of the buy-and-hold variety, that there would be absolutely no advantage to buying and holding in a tax-deferred account to a taxable account. In fact, the tax-deferred account would become a hindrance because of early withdrawal penalties, mandatory distribution rules, etc.

I'd also like to hear your thoughts on the identity of the marginal investor in the US. Is he taxable? If so, will he continue to do so as tax-advantaged accounts gain more and more prominence over time? If the marginal investor is not taxable, then why would any taxable investor remain in the market? Are firms considering this changing tax demographic when evaluating payout policy, capital structure, cost of capital, etc?

Given that the equity markets are shrinking, and tax deferred account utilization continues to grow, I imagine a future world where securities are priced as if they were tax free, and the resultant increase in share prices cause taxable holders of equities to leave the market.

Professor: Thanks for this informative write-up as well as the description of the thought-process. I really love the idea of having the share-holder use leverage to buy the stock in order to "neutralize" AAPL's cash hoard. A great outside-the-box way of approaching it.

Here is the math. If you invest $100 billion at 42%, you earn $42 billion a year. The cost of equity for Apple is about 9.5%. Even assuming that the investments are in the riskiest businesses that Apple has, with a cost of equity of 12%, the present value of $42 billion in perpetuity = 42/.12 = $350 billion.

How much risk do you feel there is to your long-term margin assumption for Apple?

Without question, they are currently beating the pants off their competitors, they have an amazing brand and they still have plenty of room to grow phone, tablet and perhaps PC sales, but can they really maintain 30% margins indefinitely?

If you look at Apple's own long-term margin history, and margins for other device makers (assuming you view apple mostly as a hardware/device maker), 30% seems pretty high.

Prof. in regards to your statement " cash is a neutral investment that neither helps nor hurts ", correct if im wrong here, given where yields are on treasuries in the US (negative real returns), and a significant portion of the cash is invested in it, isn.t that negatively impacting shareholders, erosion of capital?

Great line of thinking. However, thought it would be wiser for AAPL to hold on to its cash because

1) its cash balance is not hurting its shareholders now (like you state)

2) allows it to build sufficient cash margin when opportunities arise. Your link quotes Warren Buffet as saying “Not a dime of cash has left Berkshire for dividends or cash repurchases during the past 40 years. Instead, we have retained all of our earnings to strengthen our business, a reinforcement now running about $1 billion per month.” crazy idea maybe to buy GOOG with some leverage (market cap of $200 B :)

3) just focus on building greater and better products with the advantage of never having to worry about money!

Assuming that investing in treasuries is a negative net present value investment is a pretty sweeping indictment of the billions that are invested in it, right? If you start off with the presumption that the treasury rate is too low (relative to what you should be making), everything you build on top of it will also be flawed. (See my earlier post on "low risk free rates".)

Apple clearly knows "good ideas"Invest a part of that cash into the "iVenture Technology Fund" and get people to come to it with ideas... Maybe buy a managment team with a proven track record...May get decent returns and may also be a idea generator with Apple...As long as they do not start to screw inventors/founders the name alone should get them many, good applicants...

ProfessorI understand from your article that the preference is for buy back. However if Apple does a buyback and if the stock price does not move up (I agree that this is an assumption but given recent experiences like in case of Pfizer which did a multi billion buyback and the share price barely budged) would it not be better for the shareholders to receive dividends where the benefit is clearly quantifiable vs the uncertain price outcome of a buy back.

History, however, suggests extreme caution. Apple is a great company with multiple products that have transformed the way we operate. I personally find Itunes its most transformative success. The iphone can be derailed by another piece of technology at any time - look no further than RIMM.

No company has held on to a 500 billion plus market cap. I still view Exxon as the world's best company and I spend more money at XOM weekly, monthly and annually than I can ever spend at AAPL.

I am looking for a short entry. I believe that Apple will continue to be a great, innovative company, but I also believe the stock will lag. CSCO, INTC, MSFT and 100's of other stocks support this view. The upside is limited and the risk/reward here is no longer favorable.

Think it is early to be skeptical. Name me one company that is a 1st mover in an emerging industry, has a very strong consumer appeal and currently has a huge advantage with excellent management and whose earnings have risen 65% per year the last five years (2.27 to 27.68) but whose returns have been about 30% less than that.With a forward PE less cash of about 10 and a very conservative next 5 years growth rate of 25% per year, the PEG at less than 0.5X just makes it too early to be skeptical.

As a long term AAPL holder (2005) I have little interest in a dividend. I have always the best thing to do with the cash is to split the shares and do and buyback at the same time. This opens the stock to shareholders intimidated by the nearly $600 price tag (Yes!!!) and at the same reduces the dilution.

In the interest of a balanced view, let's say Apple went the way of RIMM what would the model look like?EBIT margins: from 36% to 15% in year 10importantly WACC increases from 9.5% from year 1 to 5, to 10% in years 6+.

Revenue growth slows at the 254 Billion a year mark in 5 years and then fluctuates close to that level as Apple defends its market share and simply tries to hold on to dear life.

My guess is that a pair of companies will unite to provide a competitive alternative to apple. Currently Samsung and Google seem to be that duo but the Android ecosystem pales in comparison to the Apple OS. The hardware battle is lost. The fashion taste may change. The key battle will be won or lost on the software front.

Apple seems to have some of Baidu’s attributes perhaps with fewer barriers to entry: Both have had exceptional growth rates (with scalability) and currently about the same PEG ratio. Their sustainable advantage, strong past price appreciation (not quite matched with their returns), good management, and strong consumer appeal puts them both in the same category, also as both value and growth.

I posted this in the facebook IPO post as we discussed drivers of value there. But thought this may be more appropriate here?

I found that the biggest driver of value was the cost of capital after 10 yrs, followed by operating margin and then cost of capital in the initial years. I dont have crystal ball and came to this conclusion when I adjusted all the inputs with a 10% increase/decrease.

I don't understand why people say Apple has $97b of cash when they have:

$10bn cash$20bn short-term investments [we can call this cash if you wish]and

$67Bn in long-term investments which can be in absolutely anything greater than 12 months and could be in junk debt, non-Usd denominated, CCC-rated CMO tranches, AND Apple does not tell us what comprises this bucket.

[source: Apple's Balance Sheet]

I mean, if a HF told you they had 10b cash, 20b in 1-yr paper, and 70bn in 'other,' would you say they had 100bn in cash?

Professor, Reliance Industries in India seems to be getting in a similar situation where they have close to zero debt and generating a lot of cash. Have you ever looked at it? They have adopted a buy-back approach hopefully to create a value for remaining shareholders.

cover your interest expenses/foregone interest income, the future earnings will comfortably. It is therefore entirely possible for an accretive deal to be value destroying and a dilutive deal to be value increasing. Matawan income tax preparation services